Leveraged ETFs are known for their natural decay. On the long term, holding a position in an N-times leveraged ETF is generally worse than holding an N-times leveraged position in the underlying asset. But few people really understand the reason, which is called beta-slippage.
To understand what is beta-slippage, imagine a very volatile asset that goes up 25% one day and down 20% the day after. A perfect double leveraged ETF goes up 50% the first day and down 40% the second day. On the close of the second day, the underlying asset is back to its initial price:
(1 + 0.25) x (1 - 0.2) = 1
And the perfect leveraged ETF?
(1 + 0.5) x (1 - 0.4) = 0.9
Nothing has changed for the underlying asset, and 10% of your money has disappeared. Beta-slippage is not a scam. It is the normal mathematical behavior of a leveraged and rebalanced portfolio. In case you manage a leveraged portfolio and rebalance it on a regular basis, you create your own beta-slippage. The previous example is simple, but beta-slippage is not simple. It cannot be calculated from statistical parameters. It depends on a specific sequence of gains and losses.
At this point, I'm sure that some smart readers have seen an opportunity: if we lose money on the long side, we make a profit on the short side, right?
The reality is more complicated for various reasons.
First, these products may be very volatile.
Second, to sell them short, you need to borrow shares from your broker. The interest rate is variable and sometimes prohibitive.
Third, borrowed shares can be called back at any time for any reason by the broker.
Smart people had the idea to take market-neutral short positions in opposed leveraged ETFs. Unfortunately, such strategies may be very sensitive to starting dates (article here).
Are all leveraged ETFs losers on the long side and dangerous on the short side? Not for some of them. For example, leveraged S&P 500 ETFs have a lower beta-slippage than most leveraged ETFs, which makes SPXU and SDSgood candidates for hedging a stock portfolio (article here).
In a trending market, beta-slippage can even become positive. Let's go back to the math: the simplest trending market is two consecutive days in the same direction. Imagine an asset going up 10% two days in a row.
On the second day, the asset has gone up 21%:
(1 + 0.1) * (1 + 0.1) = 1.21
The perfect 2x leveraged ETFs is up 44%, more than twice 21%:
(1 + 0.2) * (1 + 0.2) = 1.44
A leveraged ETF in a steady bullish trend may outperform its leveraging factor. But it depends on the sequence of losses and gains, and cannot be predicted or even calculated with a statistical model.
Here is an example with UPRO in the last twelve months:
| 12-month return 11/25/2012 to 11/25/2013 | |
| S&P 500 | 27.5% |
| UPRO | 114.4% |
The "intuitive" return of UPRO should be 27.5 x 3 = 82.5%.
Another past example using SLV (silver) and AGQ (silver 2x):
| 6-month return 11/1/2010 to 4/30/2011 | |
| SLV | 81.1% |
| AGQ | 195.3% |
During this rally, AGQ returned more than twice SLV's return.
Does it also work with leveraged inverse ETFs in bearish markets? The math works, not psychology. Fear generally makes bearish markets chaotic, not trending.
Beta-slippage is path-dependent. If the underlying gains 50% on day 1 and loses 33.33% on day 2, it is back to its initial value, exactly like in the first example. This time, the 2x ETF loses one third of its value, which is much worse than 10% in the first case:
(1 + 1) x (1 - 0.6667) = 0.6667
Without a demonstration, it shows that the higher the volatility, the higher the decay. Hence, its name: "beta" is a statistical measure of volatility. However, it is a bit misleading because the decay cannot be calculated from beta.
Update (March 2019): the drift being path dependent means not only it cannot be calculated from statistical aggregate data, but also it cannot be anticipated from price targets calculated with technical analysis methods. All we can do is observe a product's behavior on various durations. Here is an article with 3-year and 7-year time frames: Long-Term Drifts Of Leveraged ETFs. For 1-month and 1-year time frames, I publish a monthly dashboard with current decays of leveraged ETFs in stock indices, sectors, oil, gas, gold and silver. It is a must read for investors using leveraged ETFs for trading or hedging. To be notified, click "follow" at the top of this article.
Disclosure: I am/we are long SDS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: long SDS for hedging purposes
It looks like a lot of the examples you cited actually have followed the expected path in recent years. Which ETFs have had noticeable beta decay by going down when you would expect them to go up?
From:
SPY Low of Day 10/7/2011: 107.43
SSO Low of Day 10/7/2011: 17.09
TQQQ Low of Day 10/7/2011: 6.41 (record highest volume day, btw)
To:
SPY close of day 7/20/2017: 247.10
SSO close of day 7/20/2017: 112.23
TQQQ close of day 7/20/2017: 93.23
producing a total change (over about 5.75 years) of:
SPY: 130.01%
SSO: 556.7%
TQQQ: 1,354.45%
Putting $1,000 net into each (NOT taking into account ETF fees) on October 7th, 2011 should produce, according to charting software:
SPY $2,300.10?
SSO $6,567.00?
TQQQ $14,544.50?
WHERE IS THE "BETA DECAY?" Exactly. All had plenty of dips along the way. Are the charts deceptive? Are ETF fees eating a significant amount .. to boot? How much? This would go a long way in clearing my confusion on the topic of 'leveraged ETF decay.' Thank you.
SPY + 15.20% / yr Sharpe 1.43
SSO +29.95% Sharpe 1.32
The lower Sharpe of SSO is the decay
BTW... for XIV
XIV 60.48% / yr Sharpe 1.07
So SPY has the best risk adj ret.
I want to follow Gold, do you recommend buying NUGT ? it moves three times the market move?
If no, what is the best ETF to buy to long Gold?
And what about DUST if I want to short Gold?
Thank you
Not only de CARG is important. The final balance too:
$10000 10 year
1x: CARG 10%
3x: CARG 28% 28/10 = 2,80
1x: Final Balance: $25937
3x: Final Balance: $118059 118059/25937 = 4,55
Thanks for the insightful article. Do you have any comments/thoughts on LABU? Any insight is appreciated. Thanks again
Kenny
How do you define "Modified Minimum Volatility"?
Cheers from Osaka,
john
Annually rebalanced Risk Parity
Sharpe 1.0 Sortino 2.1 Max DD 22.1% CAGR 22.5%
Annually rebalanced Minimum Volatility
Sharpe 0.98 Sortino 1.9 Max DD 19.3% CAGR 19.8%
Annually rebalanced Modified Minimum Volatility
Sharpe 1.1 Sortino 2.15 Max DD 19.0% CAGR 22.2%
why 3 times leverages are not recommended for long term? What would happen if I bought now such as UWTI and kept it for long term? since I am a long term investor, it's ok for me if it goes down today, but I am sure that it will recover back in the future!
Does it have an expiration date since it deals with contracts ? and does reach ZERO and bankrupt ??
2X seems to be the ideal leverage.
Surprisingly, the solution may be quite simple: http://seekingalpha.co... .
You could rebalance based on risk parity, minimum variance, or max sharpe using the free portfolio tools on ETF replay. For me, I think splitting the difference between max sharpe and minimum variance is ideal, done quarterly.
Once you reach about $200k, better to switch to futures, if in a taxable account.
http://tinyurl.com/jyh...
I have positions in UWTI (3X crude bull) and UCO (2x crude bull). I have created scenarios of oil price recoveries for the next year using the random number generator function in Excel. Most scenarios show a gain for an oil price going from $43 to $60 in the next year. The exercise also shows what is described in this article where the gains largely depend on how it recovers. A slow steady growth is better than one with volatility.
As for myself, I just just closed out part of my position on BRZU (3X Brazil), with that basis being at a price of 7 and the proceeds at a price of 52. Yes, I've had some decay in BRZU as it went down, but the last tranche purchases like this one are the ones that really hit the jackpot, and it more than makes up for the decay of the initial tranche. And as a bonus, as BRZU went down, I was able to do some Roth conversions at my 0% tax rate in 2015 (end) & 2016 (beginning) that are worth vastly more, also contributing to the net gain. That said, I wouldn't be levering up on the S&P right now as it is a high price point; levering only works when the underlying index is very undervalued.
It's never that easy or mechanical. Good luck
Why always compare to the index ?
However, the over 80% drawdown that this would have entailed is something that very few mortals will be willing or able to calmly withstand.
Albert Einstein declared that Compounding is the MOST powerful force on earth. Not Decay.
- SSO gained 588% from the March 2009 bottom,
- SnP500 gained 170%;
Therefore SSO is performing as if it is actually a 3.46x ETF instead of a 2x ETF.
That's the power of compounding despite the 17.19%, 21.53%, and 10.90% corrections SnP500 suffered in 2010, 2011, and 2012 respectively.
* I started investing in SSO (and FAS) since August 2009 in expectation that compounding, on rallies, will trounce all other negative aspects of leveraged ETFs.
Statistically speaking, the stock markets rally 66% of the time over a very long period of time.
Buy Low - Sell High.
Surprisingly, on the basis of simulated data for years prior to 2011, even the drawdown is comparable to the drawdown of many balanced funds (actually better than all of DODBX, FBALX, FGBLX, VBIAX, WFAIX, VWELX and SWOBX, but only slightly worse than the drawdown of VWINX - 25% vs. 19%). Of course the return is pretty good: the respectable 19.6% with only three years of annual losses (-6% in 1994, -1.3% in 2001, and -0.8% in 2008).
This is almost free money with at most one hour of work every year.
Thanks a lot for the insights.
VIX ETPs are not in this dashboard.
@ $4.92 as soon as we see d
sp500 20% pullback tvix..will spike..but I want a simple explanation how to take the leading front months and figure decay even though it moves forward toward its expiration..can you send me your email to explain please..
regards
p.n.
